Treasury: Regrets, I've Had A Few

April 22, 2009

If you haven't picked up on one of the dozens of recommendations from other blogs, I recommend reading Phillip Swagel's long and detailed account of the view of the financial crisis from his seat as assistant secretary for economic policy at the Treasury Department. It's particularly useful for people like me who make a habit of criticizing government officials.

The writing is dry, but much of the subject matter is fascinating. It often explains or defends Treasury's actions during the crisis, but Swagel certainly owns up to plenty of mistakes or shortcomings. For example, discussing the emergency guarantee program for money market funds, he writes, "Nearly every Treasury action there was some side effect or consequence that we had not expected or foreseen only imperfectly."

The main impressions I get from the paper, good and bad, are:

Treasury had a fair number smart, skilled people who used a lot of detailed economic analysis in coming up with and vetting ideas. For example, it turns out they actually analyzed Feldstein's proposal to offer government loans at low interest rates but with the ability for the government to use tax liens to get its money back. (They decided it was politically infeasible.)

They were more aware about the impending crisis, earlier, than most people would think. When he arrived in 2006, Paulson apparently expected a financial system shock because market conditions had been too easy for too long.

However, they consistently and seriously underestimated the magnitude of the crisis at just about every step along the way. For example:

The prediction we made at an interagency meeting in May 2007 was that we were nearing the worst of it in terms of foreclosure starts- these would remain elevated as the slowing economy played a role and the inventory of foreclosed homes would build throughout 2007, but that the foreclosure problem would subside after a peak in 2008.

What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007. This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy.

Bureaucratic and political constraints matter a lot, and can either prevent solutions from happening, or can produce suboptimal solutions. This is probably Swagel's main point. He has a long discussion of competing proposals for mortgage modification, and how the parties in the debate--and the media--got confused about whether the proposals were benefiting homeowners or banks. Politics can also intervene much more bluntly:

the use of the TARP to support the automobile companies was straightforwardly political: Congress did not appear to want to take on the burden of writing these checks, and President Bush did not want his administration to end with the firms' bankruptcies.

Swagel provides insight into how and why things happened the way they did inside Treasury, but at times he doesn't seem much happier about the outcomes than those of us on the outside. For example, his assessment of the second Citigroup bailout in November 2008 is similar to mine:

The transaction, it turned out, did not appear to stabilize Citigroup. This could have reflected a number of reasons including that the pool of covered assets was still modest compare to a balance sheet of nearly $2 trillion, that Treasury did not provide details of the assets within the ring fence, and perhaps because many market participants saw the firm as deeply insolvent.

A key insight, however, is that under pricing insurance coverage is economically similar to overpaying for assets-but it turns out to be far less transparent. This insight underpins both the TALF and the bank rescue programs announced by the Obama administration in March 2009.

Ultimately Swagel almost reads like a critic of administration policy (under both administrations). In his playbook for dealing with a banking crisis, the first point is: "Winnow the banking system by putting out of business insolvent institutions (including through nationalization where a buyer is not at hand). The key is to avoid supporting zombie firms that squander resources and clog credit channels." However, he says, this has not happened: "the furor [over PNC's acquisition of National City] revealed that there was no prospect for putting out of business a large number of banks." Instead:

TARP support for unsustainable firms is akin to burning public money while industry stakeholders arrive at a sustainable long-term arrangement. This appears to be the American approach to systemically significant "zombie" firms-to use public resources to cushion their dissolution and restructuring.

Swagel, I'm sure, would say that I don't appreciate the importance of political constraints on policy. Fair enough. But it's not clear that he would disagree with me on what policy should be.